Planning for Executives Flashcards
Incentive Stock Options (ISOs)
• More rules and restrictions than NSOs
• Can only be given to employees
• No ordinary income tax at exercise
• Spread between FMV and exercise price is AMT preference item
• Not transferable except in event of death
• Annual $100,000 limit
• Long-term capital gains treatment
– If sold more than 1 year after exercise
– And if sold more than 2 years after grant
Disqualifying Disposition
- Results when one does not adhere to the “2-year from grant” and “1-year from exercise” holding requirements.
- Potential taxation includes ordinary income tax treatment as compensation and possible capital gains tax on the transaction.
- There are situations in which this may be a preferred strategy (e.g., based on expectation of stock price).
Non-Qualified Stock Options (NSOs)
- Few rules and regulations apply
- Do not qualify for income tax deferral on exercise
- Income tax due on spread between exercise price and FMV
- Can be granted to employees or non-employees
- No holding period requirement for stock
- Can be transferred
Exercise and Sell - NSOs
▪ Considerations:
– Available cash to pay for stock and taxes
– Risk of remaining invested in stock
– Opportunity to “lock in” gains vs. opportunity for further appreciation
– Potential for higher marginal tax bracket
▪ Cashless Exercise
– Simultaneous option exercise and stock sale
– Used anytime after vesting and before expiration
Exercise and Hold
▪ Exercise stock options to buy shares of company stock and then hold ▪ Applicable: – Prior to expiration – To capture dividends – Recognize income in a specific year – To produce LTCG on future appreciation – To meet company requirements
Stock Swap - Pyramiding
- Plan specific provision - must specifically allow
- Available for NSOs and ISOs
- Client pays exercise cost with existing shares
- Bargain element on options taxable at exercise (same as with cash exercise)
- Avoids capital gain and AGI lift from sale of stock
- “Reload” feature replaces stock used to exercise options, offers future appreciation opportunity
- Works best if client intends to exercise and hold
Option Gifting to Family
- Plan specific provision
- Can be made outright, to trust, to FLP
- Applies only to NSOs
- Provides significant estate tax benefits
- Shifts future appreciation out of the taxable estate
- Vested options are easiest
- Donor remains responsible for income tax on spread at exercise
Tandem Exercise
- For option holders with NSOs and ISOs
- Goal: AMT tax minimization on ISO exercise and hold
- Raise ordinary income to level greater than potential AMT with combination ISO/NSO exercise
- Potential downside - pay income tax now on NSOs
Section 83(b) Election
• Plan specific provision
• Exercise stock options prior to vesting
• Must be elected within 30 days of grant
• Stock subject to control and resale restrictions until vesting
• Opportunity to reduce taxes on bargain element with 83(b) election
– NSOs: tax on bargain element
– ISOs: AMT liability
• Big risk if stock declines in value
Section 457 Deferred Compensation Plans
• Must be government organization or 501(c) tax-
exempt organization.
• Contribution limit $19,500 for 2021.
• Tax on contributions and tax on account earnings are tax-deferred.
• Section 457 plans can allow for Roth contributions
and in-plan rollovers to designated Roth accounts.
NUA - What Is It?
- A strategy for retirement asset distribution
- Applies to employer securities held in a qualified retirement plan (ESOP, pension, 401K, etc.)
- Means to trade ordinary income taxation on retirement assets for LTCG treatment
NUA - How Does It Work?
- Must elect lump sum, in-kind distribution from plan (total distribution of all assets single calendar year)
- Original basis (i.e., contributions to plan) immediately taxable as ordinary income
- Remaining value (Net Unrealized Appreciation) taxed at long-term capital gain rates
- Subject to premature distribution penalty rules for qualified plans (applies onlyto original basis)
- No step-up of basis at death on NUA portion. Subject to Income in Respect of Decedent (IRD)
Registered Restricted Stock: Advantages
▪ Good for high performers—employees must meet targets before receiving shares
▪ Can carry dividend or voting rights
▪ Retains some value for employees even if price declines
▪ Capital gains treatment available on gain with 83(b) election
▪ Requires fewer shares to provide a similar level of benefit
Registered Restricted Stock: Disadvantages
▪ Restrictions may make ownership seem like an unlikely benefit
▪ Company cannot take a tax deduction for the value of the gain employees realize with 83(b) election
▪ Subject to variable accounting rules, requiring changes in value be charged as compensation expense
▪ Can involve risks for employees if 83(b) election made
Sells stock under provisions of Rule 144
— Holding Period: One year if non reporting company, 6 months if reporting company
— Trading Volume: Number of shares sold during a 3-month period can’t exceed:
▪ The greater of 1% of outstanding shares of same class being sold or if class is listed on stock exchange or quoted on NASDAQ
▪ The greater of 1% or the average reported weekly trading volume during the 4 weeks preceding the filing a notice of the sale on Form 144
— Filing Notice with SEC: Must file notice with the SEC on Form 144 if sales involve more than 5000 shares or the aggregate dollar amount is greater than $50,000 in any 3-month period.
Hedging: Zero Premium Collar
▪ Investor wants to continue to own underlying equity but hedge price risk
▪ Purchases put option and sells call option against holdings for net zero premium
▪ Specifies option maturities and degree of downside protection and upside appreciation
Hedging: Zero Premium Collar: Advantages/Disadvantages
- Advantages
▪ Hedges Downside Risk Below Put Strike Price
▪ Retains Ownership Benefits of Dividend Income and Voting Rights - Disadvantages
▪ Interim Price Risk
▪ Limited Upside Price Participation
▪ Collateral requirements for payment due at maturity
▪ Potential for CG Taxes on Underlying Stock
Position Upon Exercise
▪ “Hard to Borrow” Risk
Short Against the Box
- Occurs when an investor borrows shares of stock and sells them short, while at the same time owning shares in the same stock.
- Rules have been established to make this strategy (within certain constraints) illegal, but new strategies have been developed to accomplish the same goals
Prepaid Variable Forward
▪ Monetizes concentrated position without selling the shares upfront
▪ Diversifies a large, appreciated equity position while deferring taxation
▪ Variable contract to sell a specific value of a security in the future (i.e., the number of shares to be delivered will depend on the stock’s value at the time of delivery)
▪ Retains appreciation up to an upper limit (cap) as defined by client
▪ Protects against depreciation in stock below a lower limit (floor price)
Prepaid Variable Forward: Advantages/Disadvantages
Advantages:
▪ Substantial liquidity generated upfront
▪ No tax event until maturity
▪ Provides floor for stock price
▪ Investor retains ownership, dividends and voting rights until maturity date
Disadvantages:
▪ Ceiling on upside exposure; Investor does not participate in any appreciation of the stock above cap
▪ Self-financing; No separate loan vehicle required
Exchange Fund
▪ Private placement, exempt from registration
▪ Avoids publicity since contribution is not public sale and does not require Rule 144 filing
▪ Diversifies a large, appreciated equity position while deferring taxation
▪ Diversification occurs because many investors from different sectors contribute their shares.
▪ Diversification may, however, not be optimal.
▪ Shares of a publicly traded company exchanged for an interest in the Fund
Exchange Fund: Advantages/Disadvantages
Advantages
▪ No potential to depress market price
▪ Tax savings compared to open market sale
▪ May accept contributions of restricted securities
▪ Units receive step up basis at death
▪ May offer attractive diversification benefits
Disadvantages
▪ Illiquid for first seven years
▪ May limit total amount of restricted securities
▪ FMV of restricted securities discounted
▪ Acceptance of shares determined by fund manager
▪ May not offer desired diversification benefits
Charitable Remainder Trust
- Highly appreciated assets gifted to charitable remainder trust in return for ongoing income stream for life or trust term
- Investor receives income tax deduction for charitable gift in year gift is made
- Concentrated position is liquidated and reinvested in a diversified portfolio
- At end of trust, remainder goes to favorite charity or to family foundation
Charitable Remainder Trust: Advan/Disadvan
Advantages: • Beneficial capital gains treatment • Increase after-tax, net spendable income • Reduction of grantor’s taxable estate • Diversifies investment portfolio • Potential income tax deduction Disadvantages: • Irrevocable trust • Principal passes to charity not heirs • Minimal tax deduction reduces benefits for younger investors
10b5-1 Plans
- Pre-arranged trading plans for insiders and affiliates
- Specifies amount, price and date at which securities should be traded
- Allows trading during “blackout periods”
- May provide public with greater disclosure
